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Estate Planning 4
Sustainable Civilization: From the Grass Roots Up Estate and Financial Planning - Providing Assets for the Future - 2 - 3 - 4 - 5 - 6 - 7 - 8 FINANCIAL PLANNING INFLATION, PRICE INCREASES AND CAUSES In planning for your family to go on without you should you die, or for a future expense such as college for your child, or your retirement, history shows that failure to include the concept of inflation in your plans could be devastating. Inflation - Inflation is not necessarily the same thing as a price increase. While it appears as a general increase in prices, is in other terms a decrease in the value of currency. Modern inflation is often exampled by Germany in the 20's, when the government, lacking tax revenues to cover expenditures, and lacking the ability to sufficiently borrow, started printing money without any backing to the currency. Eventually, they printed a billion Mark note on only one side, to save ink. The German inflation includes a classic story of a man who took a wheelbarrow of money to the store to buy bread. When he couldn't get the wheelbarrow thru the door, he left it outside, certain no one would steal the worthless money. He was right, someone dumped the money and stole the wheelbarrow. We've lived with inflation for so long, that it almost sounds irrational to consider an economy without it. But nothing in economic theory for a stable community requires inflation. History - Inflation dates back to the earliest currencies. The government of Rome and other early civilizations which used precious metal coins inflated their currency by mixing other metals, clipping the coins, or making coins smaller or thinner. Coin Debasement - To most who were involved in financial transactions, it would be fairly obvious that something was happening to the currency. It would not be unusual for "old" currency to continue to be able to purchase the same goods, while a greater quantity of the "new" currency would be required for the same goods. Therefore it was still possible to hold on to purchasing power simply by keeping "old" currency. Something similar happened in the United States in 1964, the last year that our dimes, quarters, half and dollar coins were made of a silver alloy, and in 1982 when we ceased to have our penny made of copper. In early 2006, the U.S. mint estimates that by the end of the fiscal year the value of the metal in a penny, and in a nickel, will exceed 1 and 5 cents respectively, so further changes are likely, perhaps soon. What if you, like the Roman who held "old" coins out of circulation, had set aside these U. S. coins. Completely ignoring coin-collector values, we get a scenario something like the following. 1964 and earlier silver coins sell today in "junk" bags. This doesn't mean there is anything wrong with the coins, it's just that they are not sorted into coin type or conditions, and you just buy a bag of some set face value that contains a mix of dimes, quarters, and half-dollars. When originally minted, $1,000 of these coins would have contained 723.4 ounces of silver. Today due to wear the weight averages 715 ounces. For every dollar of these silver coins you had set aside, it would be worth around $7.90 today. If you had invested a dollar back in 1964 and, ignoring taxes on your annual profits, it had earnings that matched the inflation rate, each dollar invested would be worth around $6.30. The silver content of a dollar in face value of coins is approximately: Coin Type Ounce fraction Dollar .773437 Half-Dollar .72337 Quarter .72337 Dime .72337 Averaged out over the years, the old silver coins held their purchasing power, while the paper money dwindled in what it could buy. In 1981, you could have easily "lost" two rolls of pennies in your desk. 100 pennies weigh about .68 pound. Spot price for copper this year has been between $3.21 and $4.08 per pound. Your two rolls of old pennies have a value somewhere between $2.18 and $2.77. Perhaps coincidence, but this also tracks the changes in the consumer price index (see below) since 1981. Paper Currency - Inflation of paper money does not require physical alteration of the currency to shrink its valuea, and unless the paper money has a guarantee that it can be exchanged at a fixed rate for some commodity that retains value, holding the "older" paper currency is not a valid strategy. Most early paper currency was officially "backed" by a supply of precious metal; where essentially the paper money was a receipt for some quantity of gold or silver. In theory, everyone could return to the storage vault and trade in their paper for gold. In reality though it's not hard to imagine though that a few "extra" receipts get issued, or the gold makes it way out of the vault, making it impossible for everyone to get "their" gold, and making the paper currency worth less. "Fiat Currency" - "Fiat" currency, currently in use by essentially every government, does not have any tie to any physical commodity. It has value based on the government directing its use in commerce and in payments to/from the government. Currency value is free to fluctuate in response to a variety of factors. Weakness of Fiat Currency - Debasement of coins is an easy to understand aspect of the concept of currency losing value. In a fiat currency situation, there are further aspects that can readily erode the purchasing power of currency. Printing Press - The government has the ability to simply print more money and use it to pay government obligations, or otherwise put it in circulation. Government Debt - Government borrowing allows a government to spend more than it collects in tax revenues. You as an individual can borrow, and temporarily increase your money supply, but usually you must repay within some fixed period, with every debt finally due at your death. Governments have a much greater capability to roll over old debts, and add new ones, effectively permanently increasing the money supply (and inflation). Unfunded Obligations - An additional category of debt worth noting are unfunded obligations. For example, while the government has various recognized debts with specific interest rates and other terms, there are also many programs which have created debts that are far less clear in terms, but nevertheless in existence and effecting the economy. Government pensions and retirement benefits, including prospective Social Security payments fall into this category. For example, although we as military and civilian employees of the government are able to calculate the pension benefit we accrue with each year of service, the government is not setting-aside any amount to create a fund to pay such a pension. Counterfeiting - It is difficult to "fake" gold or silver. "Paper" receipt or fiat currency is inherently subject to counterfeiting, which dumps "extra" money into the economy. Documenting Inflation - Online the Bureau of Labor Statistics has consumer price index (CPI) annual changes dating back to 1914. Using their information, the same purchases that cost a dollar today would have cost only three cents if purchased in 1913. An example perhaps more on point, for someone who retired 25 years ago in 1980 on essentially a fixed income, each fixed income dollar from 1980 is only worth thirty seven cents today. Fixed income retirees during this sample time period have lost essentially 2/3 of their purchasing power. Losers to Inflation - In general in an inflating economy depositing money in fixed percentage income investments (bank accounts, bonds, etc.) can be a guaranteed LOSS for you, if the rate of return after all applicable taxes does not clearly exceed the rate of inflation. This guaranteed loss also applies to anyone who is living on a fixed income, whether from investments or a pension. Break Even in Inflation - As shown above, durable commodities that have ongoing demand, such as silver coins or even the metal copper, are a means to hold on to value vs holding "shrinking" paper money. Winners in Inflation - In a continually inflating economy, in general those who borrow at fixed rates, and use the money in carefully selected investments, will be able to pay off their loans with cheap dollars, and build fortunes thru leverage. This plan of course requires appropriate selection of investments. A simplified example using the 1964 silver coins mentioned above. In 1965 the prime lending interest rate was around 5%. Imagine a huge loan (for the time period) of $10,000 at 5% for 40 years, using the loan to walk right back into the back and leave with $10,000 face value of silver coins. Your payments would have been around $48.50 per month. You would have paid off the loan in 2004, having taken $23,280 out of your pocket over the 40 years. Those silver coins would today be worth around $79,000. Speculation Caused Price Increases - Real estate is often presented as an appropriate inflation protection investment. But in any deal, there needs to be a willing buyer and seller. There are locations where the real estate market can serve as an example of prices driven up by speculators. (The term flipping has been recently used to indicate a purchase with intent to quickly make some change and resell.) If any particular market is seen as "hot", speculators who buy for the purpose of re-selling (flipping) at a higher price, can flood the market such that the price of homes clearly exceeds the ability to pay of the "typical" family that would ordinarily be expected to purchase a home in the area. When this happens with stocks, once the speculators move on and the artificial demand abates, the stock typically falls in value. There may be those who decline to sell, hoping for prices to rise again, but all shares of the same stock being fungible, overall prices fall. When this happens in a real estate market, even after the speculators have moved on, the high prices tend to linger. Real estate, typically purchased with a mortgage, locks more owners into retaining their purchase even if they wanted to sell at a lower price. Demand Based Price Increases - Short of speculators who move into a market with the intent of deliberately driving up prices, the economic "law" of supply and demand effects prices. Demand increase can take the form of greater use per person, or an increase in the population. Of these two increases, it is of course the increase in population which rationally has the broadest effect on prices market wide, as the increase in population increases demand for virtually every product or service. If demand for a fixed supply product rises, or the quantity of a product falls while demand remains fixed, prices rise. If there is no ready substitute and people are not willing or able to do without, the price is bid higher. This type of price increase is generally not represented by the across the board increase in prices and wages that is typical of inflation, but rather it is an increase that requires reduction in some other spending. Rising Electrical Prices - Just in time for the summer cooling season, in June electrical customers of Arizona Public Service (APS) got a 7.6% increase in the charge per kwh, the third increase approved by the Arizona Corporation Commission since January. APS reported to the Commission, it lost $5.5 million during the first three months of 2006, primarily attributed to its mounting tab for fuel to operate its plants, and leading months later to increased electric rates. For example then, do you believe that electrical rates are likely to remain at this level, or rise? If you own your home it may now, or soon, make financial sense to install additional insulation, a new more efficient HVAC system, or even photovoltaic panels in a grid connected system. All of these have the potential to eliminate some portion of your present demand without a "sacrifice" in quality of living. Provided of course you act before the price of p/v panels and equipment also rises. For APS customers who install a p/v solar power system, at this writing APS will even reimburse you for part of the cost of a p/v system. In Arizona, as in many states now, the power companies are required to allow private power generation to be grid connected. This means that at such times as your home generation exceeds the use of your house, the meter "spins backwards". If for example you are on the APS plan where you pay more for power during the day than the evening, you could receive a higher value for each kwh you put into the grid during the day, than the power company charges you for what you use in the evening. Rising Fuel Prices - Also, as we enter the summer vacation season, according to Energy Department statistics the average retail price of gasoline is $2.93 a gallon, or 36% higher than a year ago, which is reported as appearing to have some impact on fuel consumption. As we saw with APS, the costs of fuel are embedded in many goods and services. Even putting food on the shelves of stores represents significant amounts of fuel for farming, processing, and shipping. For example, the higher cost of fuel for the operation of tractors is not yet reflected in the price of the already processed food on the shelves. Then the higher prices are added to the new crops, we should expect that prices will be higher in some relationship as to the amount of fuel used in growing and processing the crops. Price Change Planning - Taxation - The consensus of traditional wisdom is to expect your income tax rate to be lower in retirement than while you are employed, and defer income until after you have retired. To the converse, for estate tax purposes long-term guidance has been to get as much property out of your estate as early as possible. A change in applicable taxes clearly changes the effective value of the spendable funds you have available. This is one of those areas though where you must "keep up" with the news, as tax law keeps evolving. For example, at this time after retirement it appears to make sense to roll your TSP into a traditional IRA, for the greatly enhanced investment opportunities. In the year following retirement, if you are in a lower income and tax bracket and still investing for the long term, it may then make sense to convert the "traditional" IRA into a ROTH. Under present law you will incur a one-time taxes on the amount converted, but can then later withdraw all further accumulation of profits tax-free. If you pass on, and leave the ROTH to a young beneficiary, they will be required to make some minimum annual withdrawals, based on existing IRS rules at the time, but the required withdrawal may be less than the annual profits, so your ROTH inherited by your child could continue to be growing tax-free. Under current law. Medicare Drug Option - The prescription drug benefit took effect in 2006. Under the program you must select a plan that you believe meets your needs. If you fail to select a plan, and try to add it later, there appears to be a permanent "surcharge" added to your costs of 1% for each year you delayed. Before making a decision to not enact this coverage, perhaps you should spend the money for a thorough physical exam to determine your actual condition, and take into account medical history of your family, and exposures during your life. You need to investigate your other coverage options and weigh the costs and benefits. This plan benefits some who would otherwise not have been able to afford drugs, or who would have had to use personal funds. It also represents an increase in federal spending and in effective personal spending on drugs, and therefore may contribute to overall inflation and depending on the marketplace potentially to an increase in drug prices. Employment Based Benefits - For military and civilian federal employees our cost of living adjustments (COLA) are subject to funding in the federal budget. Be aware there are already existing programs where the COLA is set at something LESS than the annual CPI changes. You need to be prepared to deal with these in your planning. Social Security - Social Security (SS) is a tax funded benefit which can be changed, means tested, or eliminated. The amount collected in the Social Security tax exceeds the current costs of the program. The deliberate excess is then spent, with a bookkeeping entry made in the SS trust account. However, before any amount in this trust fund can be used, the money needed must be taken from the taxpayers a second time. As discussed in greater detail in a separate article, if all promised payments to the soon to retire "baby boomer" generation are actually made, the impact on the federal budget, taxes, and inflation, may be quite significant. FINANCIAL PLANNING - SECURITIES INVESTMENT FOR CAPITAL GAINS. What are securities? Beyond "cash" savings in interest bearing accounts, you can invest in securities. Think of them as a document that you purchase from a firm, which can represent a share of ownership in the firm, that the firm owes you money, or that the firm and you have entered into some type of financial agreement. Securities investment can be in the form of a "mutual fund", in which your money, and those of numerous other investors are combined to purchase not an investment in an individual firm, but in a selected spectrum of firms. Low risk of loss of stated dollar amount, but high risk of actual value loss are accounts where the interest rate fluctuates, as with a back demand deposit. These though have little “market risk”. Market risk is the risk of fluctuations in the value of securities which result from changes in overall market rates of interest. (See the discussion below on the changes in value of bonds and bond funds.) A Fixed Income Index Investment Fund is a commingled bond index fund which holds a representative sample of a wide range of bonds in which the assets of many plans are combined and invested together. Fixed-income securities represent obligations of issuers (who "borrow" your money) to repay the amount borrowed (the principal) to holders of the securities when the securities mature. "Fixed-income" refers to the fact that the coupon rate (annual interest rate) of each such security is set, or "fixed," in advance. These securities usually pay interest semiannually until maturity. Bonds and their funds carry the inherent risk that the issuer of the bond will go bankrupt, or otherwise simply be unable to pay as agreed. You, as the purchaser of a bond / bond fund, take this risk. In such a fund, you money is NOT guaranteed. In addition to the risk of non-payment, bond funds also carry market risk. This is the risk that the market price of a bond, or the entire fund, may fluctuate as interest rates fluctuate. To explain this aspect, let me example a simple one company bond. In 2001, ABC Company, seeking to expand its "widget" manufacturing facilities, marketed $1000 bonds, paying annual interest of 10%, with a maturity date 10 years in the future. You purchased one of these bonds, and at the end of 2001, ABC Co. paid you $100.00 interest. In 2002, the interest rates in general went down, and the reputation of ABC Co. gained. Together, in 2002 ABC Co. found it could further expand its facilities, and it issued more bonds. In 2002 though, it found it only needed to promise to pay 5% interest annually, for a ten year bond. What does this mean to you? In 2002, everyone who bought the 2002 bonds receives only $50 for each $1000 they invested, while YOU are still being paid $100. If you wanted to sell your 2001 bond, how much should you ask for it? If we ignore the slight value difference between the 9 years left on your bond, and 10 years on the new bonds, we directly compare the interest rates. If the 2002 bonds only pay $50 per $1000 invested, and yours pays $100 per $1000 invested, your bond is now worth $2000 if you decide to sell it. In general, when interest rates are DROPPING, you can expect a "capital gain" on a bond or bond fund. In general, when interest rates are RISING, you can expect a "CAPITAL LOSS" on a bond or bond fund. The market price fluctuation due to interest rate changes works against you as follows. If you bought the 2002 5% bond, and ABC Co. finds in 2003 that it must return to offering a 10% interest rate, your 2002 bond is only paying $50 per year, while the "new" bond again pays $100 per year. If you wanted to sell your 2002 bond, the best offer anyone would make to you would be $500, so that the interest they received from ABC Co. on the 2002 bond ($50) would be the same they would get if they were to invest their $500 directly with ABC Co. There are other "risks" to bonds, such as a "call". The example would be when ABC Co. finds, in 2002 that the interest rate is needs to pay has dropped to 1/2 of the previous year. ABC Co. may "call" some of its old bonds, pay you your $1000 principle early, and eliminate a high 10% debt from its books. Stock funds. The price of individual stocks or mutual funds comprised of such can vary sharply with changes in economic conditions, an industry, or even an individual company. Depending on the size of a decline, the total return on the stocks held by a stock fund could be negative, resulting in a loss to the fund holder. This is true whether the stocks held by a stock fund are tracking an index, or otherwise. There is no assurance that any investment in a stock funds will provide any given rate of return, or even that you will receive your original investment back. Under the current laws for corporations, you as a stockholder (directly or thru a mutual fund) essentially have no right to access the company your “own”, or contact / control your “employees”. To digress, and example a corporation. Envision a 100 unit apartment building, held by a corporation that only owns only the facility. The three corporate officers live in the building, getting a free apartment but no salary as a requirement of their management of the operation and maintenance of the building. The overall averaged net unit monthly rental income is $500 per unit. There are 10,000 shares of stock outstanding, 1% owned by each officer. The stock does not pay dividends, but instead re-invests all profits in improvements in the facility. Total annual profit for the facility is $600,000, or $60 per share. If you were looking for 5% annual earnings, in theory you might be willing to pay $1,200 per share, at a facility estimated value of $12 million. As inflation raises the dollar “value” of the facility, and the rents, it makes it look like the cash value of each share is greater. Would you buy this stock as an investment? Is it an investment? Your officers gain from the new pool and recreation area, the investment in solar panels, insulation, geothermal heat storage, etc. Do you? Your investment has no actual cash-flow value. Your investment brings no right to any physical possession or facility use. The numbers look good on paper, but you only make any profit if you can convince someone else to buy your shares at a later inflated value. It appears this is a “speculation” (perhaps something short of a gamble) where the only way you physically gain is to run a successful campaign for corporate officer, and get a free apartment (worth $6,000 per year). In a self-directed IRA, set up for example with a brokerage firm, you typically have the greatest freedom to select investments. You not only have access to stock and bond FUNDS, but to select stocks and bonds from individual firms, as well as in some cases gold coins, option contracts, and real estate holdings. Stock. One share of stock in theory represents one "piece" of ownership of the company. There may be different "classes" of shares, with different rights and benefits, such as the ability to vote on company management or major decisions, or the receipt of dividends (annual payments to you from profits). As was demonstrated in the news in the ENRON incident, there is no guarantee that an investment in a stock will produce any promised outcome. You can lose your entire investment. Individual stock selection therefore carries a greater inherent risk than investing in a stock fund, but if you select well (i.e. if you had bought Microsoft in the early 1980's) you can enjoy SIGNIFICANT profits. Bonds carry the opportunity for profit or loss, not only from the general business climate, and the specific aspects of the company you select, but from the general interest rates of the marketplace. To restate the general guidelines regarding interest rates and bonds: In general, when interest rates are DROPPING, you can expect a "capital gain" on a bond or bond fund. In general, when interest rates are RISING, you can expect a "CAPITAL LOSS" on a bond or bond fund. Gold. Herein, I bring up gold as an example of investing in physical personal possessions. Gold has the "unique" aspect in that gold, silver, and platinum in the form of American Eagles (special bullion coins produced by the U.S. Mint) are perhaps the ONLY such items that can be purchased within your IRA. (There are probably better uses for your IRA money.) Option Contract. Within an IRA, a limited number of custodians will, in a set of limited circumstances, allow the purchase of an option contract. So, what is that? Consider an option contract to be like putting a NON-REFUNDABLE earnest money deposit on a house. Your contract fee (earnest money) purchases for you the "right" to the contract, or the house, for the agreed period. In the option, you're hoping that the price of the item in the contract moves in your favor, so that you can "sell" your contract for a profit. For example: In January 2003, you pay a broker $1000 for the right to purchase 100 ounces of gold, at a price of $400 per ounce, anytime up to 01 JULY 2003. On the day you bought it, gold was selling at only $375 per ounce. YOUR hope is that between the date of your purchase, and 01 JUL 03, the price of gold goes up enough for you to make a profit. If you had wanted to actually purchase the 100 ounces in January, it would cost you $37,500. The option contract gives you the ability to "control" 100 ounces of gold, for a six month period, for "only" the $1,000. If 01 JUL 03 passes, and the price of gold has never exceeded $400 per ounce, you're probably NOT going to "exercise" your option (actually buy the gold), you probably won't find someone else to buy the option from you, and at the end of June your option will "expire" (become worthless). So, how do you make money? If you're right and the price of gold goes high enough, you can make a profit. If the price of gold goes up to $410 per ounce, then (ignoring fees) you could sell your contract for the $1000 it cost you. For every $1.00 that the price goes up beyond $410, because you "control" 100 ounces, you stand to profit $100. When the market price of the underlying commodity (in this case, gold) is making large changes, it is possible to make large profits, in a short period of time. But the price must move in your favor, within the timeframe of the contract, AND you must time your sale. If you hesitate, and the price drops back down, you have missed your opportunity. Real Estate. A relatively recent addition to the IRA investment choices offered by account providers is real estate. There are a limited number of custodians willing to handle this type of investment, but despite claims of some custodians, you are not limited to the purchase of real estate within the United States. There are additional restrictions, such as your IRA cannot purchase land that was previously owned by you, or a member of your immediate family. Accepting the restrictions, it does provide you the opportunity to, for example, make a long-term "capital gains" investment in that piece of wilderness property that you'd love to have at retirement, or purchase a rental home for a mix of capital gains and rental income to your IRA. An investment such as a rental home has the potential to provide a source of retirement income that exceeds the annuity options (both the TSP and most private sector annuities), as well as providing a solid asset that you can leave to your heirs. Beyond the tax deferred account. For most investors, it is probably in your best interest to make the maximum possible use of tax free or tax deferred investment accounts, prior to other investments. All of the mutual funds, stocks, bonds, options, etc. available inside a tax deferred account are also available in the open marketplace. A security that is not available inside tax deferred accounts is commodities trading. Commodities Trading. The basic concept is similar to that of Options Trading, described above. Your intent, is to purchase a contract (to BUY or to SELL), with the hope that the price of the commodity (gold, oil, pork bellies, beans, etc.) will change sufficiently, during the time period of the contract, so that you can sell of the contract at a profit. I've even seen commodities trading advertised on Yuma's local TV. WARNING: The risk in Commodities Trading is NOT limited to your investment money. In this type of contract, at the expiration (execution date) your are obligated for the full amount of the contract. In the Options gold example above, at the end of the six months, if you do not sell off your contract, or balance it with a sufficient counter contract, you would be obligated to make the full $37,500 gold purchase, even if the price of gold had fallen dramatically. Yes, it offers great profit potential, but it also entails great risk. Collectibles. Gold, silver, jewels, paintings, other works of art, firearms, rare books, etc. While physical items, and not "securities", they example further ideas for investment. Investment Clubs. So, with all of the investment options out there, how do you decide where to put your money? You can always "...go it alone...", the web, the Yuma library, and of course our YPG Post library has materials that can explain what to look for in investments, and how to evaluate companies. If you happen to know someone in an "investment club", and can persuade them to invite you in, you may be delighted at the wealth of knowledge available, and the guidance you receive. If there is no local club available, perhaps you may want to start one. Perhaps you've heard in the national media of the Beardstown Ladies' Investment Club. This group of women, who range from 45 to 90 achieved national fame for reported consistent annual returns of 24% and greater, far outstripping some of the best advisors at Wall Street during the same years. Estate and Financial Planning - Providing Assets for the Future - 2 - 3 - 4 - 5 - 6 - 7 - 8